More from Mr. Otmar Issing

There was certainly enough volatility. For the week, the Dow gained almost
1%, and the S&P500 was slightly positive. The Transports rose 0.4%, while
the Utilities declined 0.6%. The Morgan Stanley Cyclical index was slightly
positive, and the Morgan Stanley Consumer index was about unchanged. The broader
market was little changed. The Russell 2000 was slightly negative and the S&P400
Mid-cap index slightly positive for the week. Technology stocks were mixed.
The NASDAQ100 dipped 0.3% and the Morgan Stanley High Tech index declined 0.4%.
Yet the Semiconductors jumped 4% to go into the black for the year. The Street.com
Internet index declined 1.5%, and the NASDAQ Telecommunications index fell
1.4%. The Biotechs lost 1.5%. Financial stocks were mixed. The Broker/Dealers
gained 1.7%, while the Banks declined 0.8%. With bullion up $6.20, the HUI
Gold index recovered about 5%.

The yield curve again demonstrated some unusual hour-to-hour and day-to-day
volatility. Two-year Treasury yields ended the week up 4 basis points to 3.32%.
Five-year Treasury yields added one basis point to 3.69%. Ten-year Treasury
yields also added one basis point, to 4.09%. Long-bond yields declined one
basis point to 4.48%. The spread between 2 and 30-year government yields narrowed
about 5 basis points to 116. Benchmark Fannie Mae MBS yields jumped a notable
9 basis points. The spread (to 10-year Treasuries) on Fannie's 4 5/8% 2014
note added one basis point to 39, and the spread on Freddie's 5% 2014 note
added one basis point to 37. The 10-year dollar swap spread dipped 0.25 to
38. Corporate bonds somewhat underperformed, although junk bonds continue to
hold their own. The implied yield on 3-month March Eurodollars was unchanged
at 2.975%.

February 9 - Bloomberg (David Russell and Mark Pittman): "Pulte Homes Inc.,
the third-largest U.S. homebuilder by stock market value, is among companies
saving on 30-year debt because of proposed pension plan reforms. Yields for
corporate bonds maturing in 2020 or later narrowed this week to within 1.14
percentage points of U.S. Treasury securities maturing in more than 15 years,
the smallest gap since 1998, according to a Merrill Lynch & Co. index.
Demand for longer-dated debt has risen on speculation reforms proposed by the
Bush administration will stoke demand for the securities. Pulte, which sold
13,424 homes last quarter, issued $300 million of bonds due in 2035 on Feb.
7 at a yield spread of 1.6 percentage points"

February 9 - Bloomberg (Steve Rothwell): "Emerging market bonds, approaching
the highest prices in at least seven years, will keep rising as the economies
of countries such as Brazil, Russia and Mexico attract investors, said Mohamed
El-Erian of Pacific Investment Management Co., which manages the world's biggest
bond fund. 'You have the potential for attractive yields and selective capital
appreciation,' El-Erian, who manages $18 billion of developing-nation debt
for...Pimco... 'We are seeing first and foremost a long-term climb up the credit
quality curve. In addition we are seeing a very favorable external environment.'"

Fed Foreign Holdings of Treasury, Agency Debt fell $6.3 billion to $1.340
Trillion for the week ended February 9. "Custody" holdings are up only $4.5
billion during the first six weeks of the year. Federal Reserve Credit dropped
$7.6 billion for the week to $776.6 billion.

It was an interesting week in the currencies. The dollar was volatile, but
ended the weak with only a small gain. The Australian dollar jumped 2.4%, the
South African rand 2.2%, New Zealand dollar 2.0%, and Canadian dollar 1.54%.
On the downside, the Uruguay peso dropped 1.8%, the Japanese yen 0.8%, and
Indian rupee .8%.

February 7 - Bloomberg (George Stein): "Hong Kong's retail sales rose in December
as tourists thronged the city and rising stock and property prices prompted
local consumers to spend more. Sales rose 8.7 percent from a year earlier..."

February 8 - Bloomberg (Rob Delaney): "China's January export growth picked
up speed, defying expectations that a weaker U.S. dollar would slow the trend... China's
exports rose 42 percent from a year earlier to $51 billion yuan, up from
33 percent growth in December, and 35 percent for the whole of last year...
Imports rose 25 percent, unchanged from December. 'The long-anticipated
soft landing in China's exports is nowhere in sight,' said Tim Condon,
head of Asian financial markets research at ING Groep NV in Singapore. 'China's
trade surplus is huge and growing and contrasts with a huge and growing trade
deficit in the U.S.'"

Asia Inflationary Boom Watch:

February 10 - Bloomberg (Anuchit Nguyen): "Thailand may use as much as a third
of the nation's $49 billion in foreign-currency reserves to help finance a
1.5 trillion baht ($39 billion) plan to build subways and other public works
projects, Prime Minister Thaksin Shinawatra's top adviser said. The government
needs other sources of financing besides tax revenue, Pansak Vinyaratn said
today... The appropriate level of Thailand's foreign-currency reserves should
be at about $32 billion, he said."

Global Reflation Watch:

February 8 - Bloomberg (Lily Nonomiya): "Japan's bank lending fell 3 percent
in January from a year earlier, the smallest decline in more than six years,
Bank of Japan figures released in Tokyo today showed. Money supply rose.
Bank lending had the smallest decline since September 1998..."

February 9 - Bloomberg (Komaki Ito and Mariko Iwasaki): "Personal bankruptcies
in Japan fell 8.6 percent in December from the same month a year earlier, according
to the Supreme Court of Japan."

February 7 - Bloomberg (Eduard Gismatullin): "London office rents increased
16 percent last year, the largest gain among all European cities, the London-based
Times reported, citing a Jones Lang LaSalle study. Office rents in Brussels,
Belgium, had the second largest increase, with 7.3 percent, among the West
European cities, the newspaper said. Luxembourg rents rose 5.7 percent, France's
Lyon had a 3.2 percent and Spain's Barcelona had a 0.7 percent gain, the newspaper
said."

February 8 - Bloomberg (Brian Swint): "Industrial production in Germany, Europe's
largest economy, increased the most in eight months in December as the retreat
in oil prices eased concern about a slowdown in global growth. Output at construction
sites, factories, utilities and mines gained 1.2 percent from November..."

February 8 - Bloomberg (Francois de Beaupuy): "The French economy, Europe's
third-biggest, grew about 2.4 percent last year, the fastest pace in four
years, Finance Minister Herve Gaymard said."

February 10 - Bloomberg (Jacob Greber): "Swiss consumer confidence unexpectedly
rose in January to the highest in almost three years, reflecting optimism about
economic growth over the next 12 months."

February 7 - Bloomberg (Halia Pavliva): "Russian consumer prices rose a faster
than expected 2.6 percent in January, led by service costs, raising concerns
the government may not be able to cut the inflation rate to its target of 8.5
percent this year."

February 10 - Bloomberg (Gemma Daley): "Australia added jobs for a fifth month
in January, keeping the unemployment rate at a 28-year low and worsening a
skills shortage which the central bank says may push up wages and prompt it
to raise interest rates. The nation's currency rose and bonds tumbled after
a report showed the economy added 44,500 jobs, nine times as many as forecast..."

February 9 - Bloomberg (Gemma Daley): "Australian consumer confidence in February
remained close to its highest in almost 11 years, spurred by increased employment
and rising share prices."

February 8 - Bloomberg (Tracy Withers): "New Zealand's wages rose at the fastest
annual pace on record in the fourth quarter after the jobless rate slumped
to a 19-year low, putting pressure on employers to pay more to hire and retain
skilled workers. Wages, including overtime, for non-government workers gained
2.5 percent from a year earlier, the fastest pace since the series began in
1993..."

February 10 - Bloomberg (Dylan Griffiths): "South African retail sales rose
an annual 12.6 percent in November, close to a five year-high, as the lowest
interest rates in 24 years fueled consumer spending."

Latin America Reflation Watch:

February 10 - AP: "Brazil's industrial output surged 8.3 percent in 2004,
the biggest annual increase in 18 years, the government said Thursday. Industrial
production in December rose 0.6 percent from a month earlier and 8.3 percent
from December 2003, the government's IBGE statistics institute said. Brazilian
industry hasn't done that well since 1986, when output grew 10.9 percent, the
IBGE said."

February 10 - Bloomberg (Heather Walsh): "Chile, the world's biggest supplier
of copper, had its first budget surplus in four years in 2004, after a surge
in copper prices increased revenue. Chile had a surplus equivalent to 2.2 percent
of gross domestic product..."

California Bubble Watch:

February 10 - Los Angeles Times (Annette Haddad): "For the first time in 19
months, the year-over-year rate of housing appreciation in Los Angeles County
has dropped below 20%... The median price in the county in January rose 17%
to $414,000, according to DataQuick... It was the slimmest increase since June
2003, putting the county's median price where it stood seven months ago, after
hitting an all-time high in December at $418,000... The number of homes sold
last month fell 5% to 7,633 from a year earlier."

Bubble Economy Watch:

The December Trade Deficit was up 28% from one year ago to $56.4 billion.
Goods Exports were up 14% from December '03 to a record $71.1 billion, while
Goods Imports were up 18% to a record $131.7 billion. Goods Imports were up
27% from December 2002. The Trade Deficit for all of 2004 was up 24% from record
2003 to $617.7 billion. This was up almost 4-fold from 1998's $165 billion.

February 8 - Bloomberg (Simon Kennedy): "The U.S. Treasury wants Congress
to approve a 13 percent funding boost to cover interest payments on government
debt next year as part of its overall request for an increase in funding...
The increase would be the highest in at least 18 years and the request comes
the same day the White House predicted the federal budget deficit will rise
to a record $427 billion in the current fiscal year, which ends Sept. 30.,
forcing the Treasury to issue government securities to plug the gap. Interest
on debt payments will rise an estimated 8.2 percent to $347.9 billion in fiscal
2005, from $321.6 billion last year."

February 9 - Bloomberg (William Selway): "U.S. state governments' revenue
from taxes rose during the last fiscal year at the fastest pace since 2000,
buoyed by an increase in personal income and $8 billion in tax increases, according
to a study. State governments' tax revenue rose 7.5 percent to $501.9 billion
during the 2004 budget year, according to the Nelson A. Rockefeller Institute
of Government in Albany, New York. It is the fastest growth since tax revenue
rose 8.7 percent four years earlier as benchmark U.S. stock indexes surged
to records."

February 7 - The Wall Street Journal (Sarah Lueck): "To see how Medicaid is
devouring state budgets across the country, take a look at Mississippi. Over
the past five years state and federal spending in Mississippi on Medicaid --
the health program for the poor and disabled -- has doubled to $3.5 billion.
Fully one-quarter of state residents are in the program. 'Medicaid is a cancer
on our state finances," says Mississippi Gov. Haley Barbour..."

February 10 - San Francisco Chronicle (Peter Fimrite): "The Golden Gate Bridge
District, still reeling from a back-breaking budget deficit, outlined a series
of proposals Wednesday to bring in more cash, including a $6 toll and possible
charges to pedestrians and bicyclists crossing the span."

February 9 - The Wall Street Journal (Ryan Chittum): "Office-building values
jumped in the fourth quarter as the leasing market began strengthening, while
apartment values rose more slowly, but buyers are still paying a considerable
premium for commercial real estate, according to a new study. Office values
jumped 3.3%, the most in two years, to $138.59 a square foot in the fourth
quarter from $134.13 in the third quarter, according to the study of the top
50 U.S. markets prepared by Reis Inc.... Apartment values were up 1.4% to $72,128
a unit in the fourth quarter from $71,132 in the third quarter. For the year,
office values were up 2.8%, compared with a 5.6% decline in 2003. Apartment
values rose 4.8% in 2004, while they declined 0.33% in 2003."

From Freddie Mac: "With no dramatic change in our interest-rate forecast or
GDP estimates, forecasted housing starts are the same as last month's projections.
We show a 3% decline to about 1.90 million units in 2005 and then falling to
around 1.80 million units in 2006. Similarly, total home sales are forecasted
to fall by 3% to 7.66 million units in 2005 (marking their second best year)
and then to around 7.27 million in 2006. Gradually rising mortgage rates should
help slow home price appreciation from 10.5% in 2004 to around 7.8% in 2005
and to around 6.3% in 2006. Given lower home sales, less new construction,
fewer refinancings and slower house-price appreciation, overall mortgage originations
are expected to decline by about 6 % to $2.6 trillion in 2005 and to $2.3 Trillion
in 2006. The refinance share of new mortgage applications should decline to
41% in 2005 and to 33% in 2006. There's enough momentum from last year's
strong housing market to maintain strong mortgage debt growth in 2005. We expect
mortgage debt growth to average around 12.6 percent in 2005 and then ease to
11.0 percent in 2006."

Financial Bubble Watch:

February 9 - Bloomberg (Karen Brettell): "U.S. derivatives professionals got
as much as much as 20 percent more in bonuses in 2004 as banks struggle to
keep their best traders from joining hedge funds or competitors, recruitment
consultants said. The top managing directors in equity, credit and interest-rate
derivatives at the largest banks received average bonuses of $3 million, rising
from $2.5 million last year, said Mike Karp, co-founder of Options Group, a
New York-based executive search firm. 'With hedge funds increasingly hiring
experienced traders, banks are finding it harder to hire or keep staffers with
experience,' Karp said. The best-paid managing directors in derivatives trading
will have received between $3.5 million and $5 million, he said."

February 7 - Bloomberg (George Stein): "Merrill Lynch & Co. and UBS AG
vaulted into the top three among merger advisers, joining perennial leader
Goldman Sachs Group Inc., in the hottest U.S. takeover market since 2000. About
$150 billion of acquisitions were announced since January, up 32 percent from
the first five weeks of 2004, according to data compiled by Bloomberg....
'The way 2005 has begun, we could rapidly get back to the peak levels of 1999
and 2000,' said Scott Bok, president of Greenhill & Co., a merger advisory
firm... 'Some of the large deals will set off a chain reaction.'"

Mortgage Finance Bubble Watch:

February 7 - The Mortgage Bankers Association: "Commercial and multifamily
mortgage bankers' loan originations set a record during 2004... The
$136 billion in loan originations reported for 2004 were up by 16 percent
from the $117 billion reported in 2003. MBA also reported that loan
originations in the fourth quarter were the highest ever recorded in
MBA's quarterly survey. The fourth quarter total of $42.7 billion was $7.1
billion above third quarter 2004 volume and $3.8 billion above fourth quarter
2003 volume. 'The continued availability of capital from lenders and demand
from borrowers combined to produce new record loan originations in 2004,'
noted Douglas G. Duncan, MBA chief economist... 'With commercial property
values strong, interest rates low, the economy growing, and real estate markets
starting to improve, 2005 looks to produce more of the same.'"

Assuming Countrywide's volumes remain indicative of mortgage lending for the
entire industry, 2005 is off to a strong start. At $2.1 billion, Average Daily
Mortgage Applications were at their strongest level since last March (up 19%
from Jan. '04). The Mortgage Loan Pipeline was up slightly from December to
$47.8 billion, fully 25% above year ago levels. Total Fundings ($28.5bn) were
down from December's $34.7 billion, but were up 38% from January 2004. Purchase
Fundings were up 37% from a year earlier to $12.7 billion and Non-purchase
(refi) Fundings were up 37% to $15.6 billion. At $15.1 billion, ARMs were up
from the year ago $9.5 billion to 53% of total fundings. Home Equity Fundings
were up 75% from January 2004 to $2.7 billion, and Subprime was up 92% to $3.9
billion. Bank Assets increased about $2.3 billion during the month to $43.3
billion (up 113% y-o-y).

Subprime mortgage originator Accredited Home Lenders Total Assets expanded
at a 53% rate during the fourth quarter to $6.14 billion. Total Assets doubled
in twelve months, and were up from $1.80 billion to begin 2003. Shareholder's
Equity ended the year at $212 million. Origination volume was up 56% for the
year to $12.4 billion.

More from Mr. Otmar Issing

We are this week provided a few moments of central bank sanity from our old
favorite ECB Chief Economist, Mr. Otmar Issing. I have excerpted from his short
paper "Monetary Policy and Asset Prices," available online at www.boersen-zeitung.com.

"Which role should asset prices play in the conduct of monetary policy?
This question has gained more and more attention in recent years. However,
the answers are anything but straightforward..."

"Prevention is the best way to minimize costs for society from a longer-term
perspective. Central banks are confronted with this responsibility,
but there is no easy answer to this challenge. So far, only some tentative
conclusions can be drawn."

"First, in their communication central banks should certainly avoid
contributing to unsustainable collective euphoria and might even signal
concerns about developments in the valuation of assets."

"Second, the argument that monetary policy should consider a rather
long horizon is strengthened by the need to take into account movements
of asset prices."

"Finally, it should not be overlooked that most exceptional increases
in prices for stocks and real estate in history were accompanied by strong
expansions of money and/or credit."

"With stable prices money serves society best as a unit of account,
medium of exchange, and store of value. Any index of consumer prices
covers only a segment of prices in an economy - although an important
one. Prices of assets like real estate or equities are excluded from
the definition."

"We have learned on many occasions that excess liquidity can show
up in excessive asset valuations and not only in consumer price inflation. Sooner
or later, then, unsustainable asset price trajectories may translate
into sizeable risks to price stability -- in either direction --
and often much further down the road as the long-run fallout of the Japanese
bubble of the late 1980s has shown."

"To my mind the risks associated with asset price inflation and subsequent
deflation are an important additional reason for paying close attention
to money and credit, over and above the regular and well-established
link between money and consumer prices."

"Thus, a monetary policy strategy that monitors closely monetary and
credit developments as potential driving forces for consumer price
inflation in the medium and long run has an important positive side effect:
it may contribute at the same time also to limiting the emergence
of unsustainable developments in asset valuations. In other words: as
long as money and credit remain broadly well-behaved the scope for financing
unsustainable runs in asset prices should remain limited."

"The tendency of modern textbooks on monetary theory and policy to
relegate money and related concepts to inconsequential footnotes can
be no comfort. What is the role of liquidity, financial frictions
and the flow of funds for the real economy and the relation of money
vis-à-vis a broader range of asset classes? While a full grasp of
the interplay between the real economy and monetary and financial variables
remains elusive, the asset price cycle playing out in the late 1990s
and peaking in early 2000 has again forcefully brought to the front the
importance of careful analysis of financing flows and balance sheets
considerations, on the side of households, the corporate sector as
well as the financial system."

"The more the monetary and financial side of the economy is given
its proper weight in the ongoing analysis of central banks and in their
monetary policy deliberations and the more extended its policy horizon,
the lesser will be the need to contemplate exceptional 'escape clauses'
for the monetary policy strategy. At the same time, such a strategy
offers a framework to face up to central banks' responsibilities in this
realm..."

It is refreshing to read central banking philosophy from the well-grounded
ECB perspective. What a contrast to that espoused by the Greenspan Federal
Reserve. The ECB recognizes the necessity for adopting a long-term focus, while
the Fed's realm is the short-term and zealous activism. Mr. Issing exhorts
that "central banks should certainly avoid contributing to unsustainable collective
euphoria." Mr. Greenspan has over recent years become a proponent of "the New
Economy," derivatives, structured finance, and even the liquidity and "flexibility" benefits
of an expansive hedge fund community. Indeed, the activist Fed specifically
targeted leveraged speculation and mortgage borrowings as the key reflating
mechanisms in the post-technology Bubble environment. With short-term expedients
come long-term costs and uncertainties.

There is today - in The Intoxicating Global Liquidity Bubble World - little
appreciation that Mr. Greenspan's short-term activism is coming home to roost.
Back in November he made a remarkable comment: "Rising interest rates have
been advertised for so long and in so many places that anyone who has not
appropriately hedged this position by now obviously is desirous of losing money." If
only the world's marketable securities-based Credit systems and the massive
global pool of speculative finance could be managed so easily. I would argue
that the essence of Mr. Greenspan's comments lie at the very heart of failed
Fed policymaking - and attendant Monetary Disorder.

Ponder for a moment a scenario where, let's say, the Fed had warned in 1999
that NASDAQ was poised to decline. Duly warned, investors, day-traders, Wall
Street proprietary trading desks, hedge funds and others would surely have
simply gone out and purchased put options and locked in bull market gains (choosing
to buy insurance while playing the hot game for all it's worth!). In theory,
life in the markets would have been just swell.

But the reality of the situation was quite to the contrary. NASDAQ was in
a powerful yet unsustainable Bubble. When the Bubble eventually burst, those
that wrote NASDAQ derivative exposure were on the hook for major losses. And
it is important to appreciate that those writing put options and other derivative
protection are generally thinly capitalized financial institutions and speculators.
Such players must rely on "dynamic trading" hedging strategies that entail
selling/shorting, in this case, NASDAQ stocks and instruments to offset the "insurance" exposure
that escalates when a market commences a major decline. And when a large portion
of the (fully-invested) marketplace acquires put options to "lock in a bull
market," this assures massive "dynamic" selling into a declining market with
few willing and able buyers. The inevitable outcome is a collapse in marketplace
liquidity.

Yet, there is more to this basic NASDAQ/"market hedging" example that may
offer some insight into the current peculiar bond market environment. Let's
say the Fed warned of the coming NASDAQ decline in mid-1999. And, over the
following few months, participants aggressively shorted tech stocks and NDX
futures, while loading up on puts. The writers/sellers of these derivatives
would then partially hedge their exposure by shorting individual stocks and/or
indices. Hedges and bearish bets, rational ones at that, would be put on in
size.

End of cycle euphoria and Bubble dynamics would, virtually by definition,
create ample liquidity to accommodate these sales. There would be, as well,
critical dynamics in the "economics sphere" to match those in the "financial
sphere." Importantly, this same "blow-off" liquidity would tend to significantly
distort ("inflate") fundamental factors such as company/industry revenues,
earnings, and cash flow. Arguably, bull markets and booms create their own
liquidity and "positive" fundamentals. As such, contemporary finance demonstrates
a proclivity to foster extraordinarily unstable marketplaces replete with,
on the one hand, seemingly exceptional fundamentals and, on the other, rising
short and derivative positions. Moreover, these bearish positions - as Bubble
dynamics again make certain - reside in "weak hands." The bloodied bears and
the derivative players with shorts become open game in what becomes a wildly
speculative marketplace. This is one aspect of the very unstable nature of
financial Bubbles and why the ECB is correct in arguing that they must be dealt
with long before they burst.

I strongly argue that such a scenario - the confluence of Bubble dynamics,
central bank warnings, system-wide hedging, and acute "economic sphere" distortions
- create the perfect backdrop for major market dislocation. And, in reality,
the NASDAQ100 index did double from its elevated June 1999 level during the
subsequent nine months. A historic short-squeeze and enormous derivative positions
played instrumental roles in this spectacular market breakdown. And while an
overt Fed warning was not a factor, the Fed was raising rates and was exhibiting
increasing public concern. The existence of highly liquid markets for derivative
protection clearly played an instrumental role in fostering boom and bust dynamics
and acute financial fragility.

While some participants do effectively use derivatives to, it is impossible
for a large portion of the market to successfully hedge against a major market
move. I assert that the circumstance of major share of the marketplace hedging
market exposure during the late-stage of Bubbles greatly increases the probability
one of two scenarios: One, the market commences a downward spiral, overwhelmed
by self-reinforcing "dynamic" derivative-related selling pressure. The second
scenario - and I argue passionately that Bubble dynamics increase the likelihood
of this outcome - is one of a final "classic" spectacular marketplace blow-off:
the animated crowd recognizes that the game is nearing its end and puts in
place its bearish bets and hedges, only to get run over by the final short-squeeze
and buyer's panic melt-up (including the throngs of attentive speculators buying
in front of those caught short). Marketplace dynamics virtually assure that
the crowd and their derivative counterparties will be forced to unwind hedges
in the final dislocation. Not only does this lead to heightened marketplace
volatility and indecision, it also exacerbates the widening chasm between current
market prices and prospective economic values.

One other key aspect of the final short covering/derivative unwinds/speculator
euphoria melee is not as obvious: This process creates massive liquidity that
perpetuates and exacerbates the attendant boom in the industry/economy ("economic
sphere"). The financial sphere will have over time expanded and evolved to
over-finance the Bubble, while the most aggressive risk-takers ("proved right")
will have been elevated to top decision-making positions. Support from the
political establishment also reaches full bloom. Importantly, this final destabilizing
liquidity onslaught fosters the most egregious excesses throughout the real
economy. These include misallocation of resources and - certainly as we saw
throughout the tech/telecom sectors - over and mal-investment that ensures
the collapse of industry profits as soon as the unsustainable liquidity bulge
runs its course.

This brings us to the current environment. Despite Mr. Greenspan's warnings
and six Fed rate increases, the U.S. Credit system's liquidity bulge has at
this point anything but run its course. The homebuilding and consumption boom
runs full steam ahead. Should we have expected anything less? It is my view
that interest-rate markets succumbed to a marketplace dislocation not unlike
NASDAQ in that fateful period second-half 1999 to early 2000. An enormous amount
of interest-rate hedging was put in place that was, in reality, untenable.
Again, I would assert that the Fed's warnings of higher rates and the market's
rational reaction (large-scale hedging and bearish speculating) assured either
a self-reinforcing downward spiral in bond prices (spike in rates) or an unfolding
major "squeeze," derivative unwind and destabilizing drop in rates. We are
witnessing the latter.

With nightmares of 1994 - and cognizant of today's highly leveraged and fragile
financial landscape - the Fed expressly erred on the "side of caution." Ample
warning, extraordinary "transparency," and promised ultra-baby step (with pauses?)
rate hikes were incorporated specifically to accommodate the leveraged players.
At the same time, the financial sector was afforded ample time and opportunity
to adjust its products and programs to assure uninterrupted boom-time Credit
Availability and liquidity. The Mortgage Finance Super-industry, in particular,
developed and aggressively marketed variable-rate products, interest-only loans,
and flexible home equity lines of Credit. Wall Street investment bankers focused
on issuing variable-rate corporate debt, while the "financial engineers" in
structured financed set their sights on transforming $100s of billions of variable-rate
and subprime mortgage loans into enticing collateralized debt obligations (CDOs),
MBS, ABS, and myriad derivative products.

The Credit system hasn't missed a beat, and that's a problem. The ongoing
liquidity onslaught throughout the U.S. and global Credit system, echoing NASDAQ
1999, has wreaked distortion havoc on both the "economic sphere" and the "financial
sphere." Conspicuously, over-consumption, massive Current Account Deficits
and unprecedented central bank dollar security purchases have taken center
stage. The greater the U.S. lending and spending excesses, the greater the
force of foreign central bank recycling operations back to the Treasury and
agency markets. And talk of a paradigm shift to permanently low market rates
(all too reminiscent of "blow-off" notions of enduring tech multiples) grows
louder. Bubble distortions - foremost liquidity excess - under the façade of
amazing fundamentals have played a major role in inciting a short-squeeze and
unwind of interest-rate hedges throughout the Credit market.

And while on the surface not as spectacular as the technology stock melt-up,
we do have the homebuilders. Further evidence of blow-off excess can be found
in paltry corporate, junk, ABS, and MBS spreads. Credit default swap prices
have sunk as well. Globally, emerging bond spreads are extraordinarily narrow,
while equity markets remain red hot. Basically, liquidity excess and multi-year
low risk premiums have become the norm throughout global finance. The system
is poised for another Trillion plus year of Mortgage Credit growth.

And no discussion of Bubble distortions and potential dislocation in the interest-rate
markets would be complete without some mention of GSE balance sheets. Unfortunately,
Fannie and Freddie haven't issued financial statements in awhile. But looking
at 2003 year-end statements, Fannie and Freddie had at the time combined short-term
liabilities approaching $800 billion (total assets of about $1.8 Trillion).
Let's assume those numbers have stayed about the same, and then add an additional
$200 billion or so for the FHLB. We can throw out a rough estimate of $1 Trillion
of GSE short-term borrowings. As derivative kings, the GSEs have aggressively
entered into interest-rate swap agreements and acquired other derivative "insurance" to
hedge their mismatch between the expected life of their (generally) mortgage
assets and the average duration of their borrowings.

We can only hope that the GSEs are more adept at derivative hedging than they
are accounting. But one can look at the current yield curve environment and
see plenty of potential for error. Let's say the GSEs entered into swap agreements
to hedge the risk associated with a Fed tightening cycle. In such a swap, they
might choose to pay some fixed rate to receive whatever is the going 10-year
Treasury yield. Historical models would forecast that 10-year yields would
likely experience a greater increase in yields than the rise in Fed short-term
rates (recall 1994) - models would expect 10-year yields to rise and the yield
curve to steepen. This swap would be expected to hedge against the rising cost
of their short term debt. But what would happen if the cost of financing the
massive GSE short-term debt rose but 10-year Treasury yields actually dropped?
And what would be the consequences if such hedges began to falter for the GSE
and throughout the marketplace? Would players be forced to restructure their
hedges - perhaps forced to buy the 10-year (on leverage, of course) and short
the 2-year instead? And would the yield curve effects of such a move by huge
market players force others to cover short positions and unwind hedges out
the yield curve, while shorting, say, 2-year Treasuries? Am I suffering from
a wild imagination when I ponder the possibility that such operations could
be inciting destabilizing yield curve gyrations and derivative hedging tumult?

Well, enough conjecture for this week. But a very fascinating dichotomy is
developing in the marketplace. After beginning the year with a hiccup, global
bond and equity markets have generally regained their strong momentum (U.S.
equities are lagging). And we see this week continued price gains in the energy
markets, as well as the resurgent commodity markets. Furthermore, the "commodity
currencies" were quite strong this week. While I appreciate that many are calling
for the demise of the "reflation trade" - long commodities, commodity currencies,
and emerging markets, while short the dollar - recent weakness may prove only
a pause that refreshes. It is also worth noting that economists have begun
to revise U.S. growth higher, and there are signs the global economy is demonstrating
similar resiliency (not surprising considering the interest-rate and liquidity
backdrop).

So if reflation retains its vigor; economies their resiliency; and the Global
Liquidity Bubble its tenacity; what the devil is the 10-year Treasury yield
doing at 4.09%? Has the recent drop in yields (and yield curve gyrations) been
fundamentally or technically driven? Are we in the midst of the best of times
for the bond market or, instead, an environment characterized by instability
and dislocation? How exposed has the marketplace become to an abrupt reversal
of fortunes? I suspect that short covering and the unwinding of derivative
hedges is placing the marketplace in an increasingly vulnerable position. And
it's always these abrupt market "Vs" that cause the derivative players the
most grief. As was the case with NASDAQ, one day derivative traders can be
panic buyers only to have a market reversal hastily transform them into aggressive
sellers.